(Bloomberg) -- Wall Street traders might not be showing just enough concern about long-term price pressures.
West Texas crude oil has climbed more than 35 percent from its June low and this week touched a level unseen in more than two years. While that has nudged up traders’ expectations about consumer price gains, market inflation-linked gauges known as breakeven rates are still pricing in a pace that’s below the Federal Reserve’s 2 percent annual target. Some investors warn that might be a mistake.
“The bond market is currently not discounting this inflation risk, they are mispricing it,” said Ben Emons, chief economist and head of credit portfolio management at Intellectus Partners. “Producer prices will spill over into CPI, which will be lifted also by energy effects. This is all a form of overheating that may lead to higher inflation.”
Emons said he’s overweight Treasury Inflation Protected Securities versus nominal Treasuries. The gap between yields on nominal bonds and TIPS, the breakeven rate, predicts that the headline gauge for U.S. consumer prices will only increase at 1.95 percent over the next three decades.
And while the one-year inflation swap has seen an additional 0.3 percentage point of price-gain pressure factored in since August, five-year five-year forward inflation swaps have barely budged. The latter measure shows where traders see inflation for the five-year period beginning in 2022 and is regarded as a better long-run indicator.
The gap between market pricing and economic assumptions matters. Inflation has been the one measure that has escaped the Fed’s targets despite years of quantitative easing. As investors continue to balance the prospect of further tightening in the face of low inflation, a sudden shift in the price outlook could have broader economic implications with some investors already warning about the risk of a recession.
The clearest sign, yet, that most bond traders aren’t fretting about inflation is the relentless narrowing of the difference between short- and longer-term Treasury yields. Returns on longer-dated debt tend to be more sensitive to changes in interest rates and suffer more from inflation surges, so the flattening of the curve suggests a degree of nonchalance.
The spread between five- and 30-year yields fell to as little as 77 basis points on Wednesday, marking the flattest curve since November 2007, right before the start of an 18-month recession. The difference between two- and 10-year maturities is also close to the smallest in a decade.
Rick Rieder, global chief investment officer of fixed-income at BlackRock Inc (NYSE:BLK)., says the curve is out of whack, and he points to signs of upward pressure in salaries as an indicator of price pressure.
Measures such as the Atlanta Fed’s wage tracker and company earnings reports suggest that “we are seeing real wage inflation,” Rieder said in a Bloomberg Television interview on Nov. 3. “Growth is going to be really solid and wages are accelerating.”
And if that’s not enough, add a weakening U.S. dollar to the rebounding commodity prices. Inflation should start to accelerate later this year as the effect of that depreciation flows through to import prices, according to Nicholas Gartside, chief investment officer for fixed income at JPMorgan (NYSE:JPM) Asset Management.
“When you look at inflation, the reality is it’s crazy to see it much significantly higher in the long term,” Gartside said. “But in the short run, watch the dollar.”